After a brief period of joint reflection, when increased government spending was coordinated with innovative stimulus programs, we return to central banks as the sole bulwark against stagflation. The current disconnect between fiscal and monetary policy leaves the guardians of financial stability – and their independence – dangerously exposed to attack.
Walking a tightrope between curbing runaway inflation and plunging the economy into recession poses a dilemma for the European Central Bank. While hawks on its board of governors are calling for an imminent end to quantitative easing and a quick end to negative interest rates, removing stimulus too quickly could easily lead to a sharp downturn next year for the still precarious economy of the euro zone. The saving grace is that, so far at least, there is little evidence of a spiral in wage increases. This is exactly where bloc governments can help, by mitigating the impact of soaring energy prices on consumers to mitigate second-round inflationary effects.
The European Union won a big victory last year by creating the 800 billion euro ($840 billion) Next Generation fund to offset the economic hardship of the pandemic, but its collective fiscal response to the invasion of Ukraine by Russia was lackluster. The great strength of the EU is its flexibility in the face of adversity; it should combine the coordination of its military response and sanctions with a package of measures to support growth while mitigating the impact of the war on prices.
The Bank of England’s task is even more difficult given the tax increases introduced by Chancellor of the Exchequer Rishi Sunak. It’s not a good idea for a central bank to raise interest rates in its fourth straight meeting while suddenly warning of impending recession risks. Rising borrowing costs can only aggravate the cost of living crisis, hence the growing divisions in the Monetary Policy Committee between members who prioritize the need to calm inflation and those who are worried about the government’s fiscal tightening.
The British government seems deaf to calls from financial experts to mitigate the coming decline in living standards. As the BOE appears to be losing its appetite to fight rising consumer prices and predict stagflation, traders and investors are understandably growing wary of sterling assets.
The Federal Reserve, meanwhile, sees no obstacles and is accelerating its tightening. This is widening the interest rate differential against other currencies, further propelling dollar strength and wreaking havoc on the foreign exchange market, to the particular detriment of emerging market economies. But the US central bank has little choice but to catch up after too much government stimulus. The prospect of political stalemate after November’s midterm elections does not bode well for the already shaky administration of President Joe Biden. At least with the former Fed chairman now in charge of the Treasury, there should be hope for synchronization between the fiscal and monetary response to the economic challenges ahead.
Actively deflating the economy to cool overheated labor markets and trigger demand destruction is what the Fed and the BOE are pursuing. This not only risks wasting the trillions spent on pandemic recovery efforts, but it could also be out of control. The cure could be worse than the disease, undermining already wavering confidence in the ability of monetary authorities to fulfill their mandate.
No one wants to go back to politicians deciding interest rates. There must therefore be an awareness of the limits of what monetary action alone can achieve when the world has been effectively shut down and then turned back on amid global supply chain disruptions and a climate-induced energy crisis. war. Central bankers have little or no control over supply and can only suppress the demand they have so recently fueled so fervently. Governments can tinker on the production side, but only where it makes commercial sense. It takes a long time for infrastructure or other large projects to generate a significant economic effect, but fiscal policy could do much more, especially with taxes and investment incentives.
Stocks and bonds are already flashing red on the economic dangers ahead. Fiscal and monetary policies can and should be coordinated without undermining the independence of either group of decision makers. It is time for world authorities to repeat the creativity they have shown during the pandemic. They should act now, in haste.
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This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Market Strategist for Haitong Securities in London.
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